Thursday, October 11, 2007

Tightening consumer bankruptcy laws was supposed to be good for lenders. Banks pushed hard for the legislation, which made it virtually impossible for a consumer with a salary to file for bankruptcy. Borrowers could no longer go bankrupt, so they would have to repay their loans — right? Unfortunately, it seems that this is what lenders were thinking, and their overconfidence brought us to the lending liquidity crisis everyone is talking about now.

When the bankruptcy law changes were being considered, there were voices saying that the changes would actually benefit consumers. Bankruptcy is a stain on your reputation, they said. Instead, a penniless consumer could simply stop making payments, and that would be the end of the matter. In practice, there would be nothing a lender could do about it. Bankrupt or not, if a person does not have any money, you can’t get any money from them.

For all its faults, bankruptcy is at least an orderly process. The court finds out who all the lenders are and decides who gets what. By contrast, the new un-bankrupt consumers, financially bankrupt but not allowed to file for bankruptcy, are about as easy to sue as the “un-dead” of zombie movies. The situation can turn into a free-for-all among the lenders involved, fighting it out against each other in court with legal ground rules that are as clear as mud. Lenders who want to take advantage of the tighter bankruptcy laws can spend enormous sums of money on lawyers.

Even worse from the lender’s point of view, the un-bankrupt are not subject to any of the restrictions that bind a person who is legally bankrupt. An un-bankrupt consumer can hide their money, give it to friends and family members, spend it, pay their lawyer anything they want without having to wait for a judge’s approval. The chances of a lender who sues an un-bankrupt person of getting any money before the defense lawyer gets it? Not particularly good.

Others can debate exactly what the standards for consumer bankruptcy should be. The point here is simply that lenders who thought the tighter bankruptcy laws would benefit them were sadly deluding themselves. And it seems many of the largest consumer lenders brashly went out and lent money to just about anyone.

The problem was kept under wraps for a short time by the low initial interest rates of many loans. Sometimes called “teaser” rates, these initial fixed interest rates gave way to market rates at some point, resulting in monthly payments that everyone knew all along the borrowers would not be able to pay.

The problem came to the surface last year in states with job market problems, such as Georgia and Michigan. It is clear now that it has gone national. All across the United States, consumers are defaulting on loans in unprecedented numbers. This is not, as some have suggested, the result of the current economic slowdown. The lending crisis and record high oil prices appear to be the two important causes of the slowdown.

The lending liquidity crisis is affecting banks in various countries, but it is important to note that it is limited to loans made in the United States. It was the United States that changed its personal bankruptcy laws, and the bad loans at the center of the crisis are all located in the United States.

In the short term, the most important thing that needs to be done is to prop up the banking system. Without strategic intervention to prop up troubled banks, the banking system worldwide could collapse, with all the major banks going bust. Governments, central banks, and even money center banks have stepped in in recent months with unprecedented amounts of cash to prop up troubled banks in the United States, Germany, and the United Kingdom, and this will have to continue as new trouble spots emerge.

In the long run, the problems caused by lender overconfidence can be cured with some very simple reforms in lending laws. Lenders need to stop lending money to consumers who do not have the income to repay the loans. It is not necessary to make it illegal for lenders to make these loans, as some have suggested. But when lenders choose to lend money to a consumer who is patently unqualified to borrow it, the lender should be prevented from going to court to collect the money from the consumer. The courts do not exist to prop up incompetent and unscrupulous lenders, and that particular abuse of the legal system could be stopped with a relatively simple piece of legislation.

Of course, most lenders would be very careful not to make any loans that were not legally enforceable, so that change in the law would also ensure that the overconfidence of lenders that led to the current crisis would not come back to create another crisis in the future.